Note 31: Fair Value of Financial Instruments

Transcription

1 Note 31: Fair Value of Financial Instruments We record trading assets and liabilities, derivatives, available-for-sale securities and securities sold but not yet purchased at fair value, and other non-trading assets and liabilities at amortized cost less allowances or write-downs for impairment. The fair values presented in this note are based upon the amounts estimated for individual assets and liabilities and do not include an estimate of the fair value of any of the legal entities or underlying operations that comprise our business. Fair value represents the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between willing market participants at the measurement date (i.e. an exit price). The fair value amounts disclosed represent point-in-time estimates that may change in subsequent reporting periods due to changes in market conditions or other factors. Some financial instruments are not typically exchangeable or exchanged and therefore it is difficult to determine 178 BMO Financial Group 197th Annual Report 2014

2 their fair value. Where there is no quoted market price, we determine fair value using management s best estimates based on a range of valuation techniques and assumptions; since these involve uncertainties, the fair values may not be realized in an actual sale or immediate settlement of the instruments. Governance Over the Determination of Fair Value Senior executive oversight of our valuation processes is provided through various valuation and risk committees. In order to ensure that all financial instruments carried at fair value are reasonably measured for risk management and financial reporting purposes, we have established governance structures and controls, such as model validation and approval, independent price verification (IPV) and profit and loss attribution analysis (PAA), consistent with industry practice. These controls are applied independently of the relevant operating groups. We establish and regularly update valuation methodologies for each financial instrument that is required to be measured at fair value. The application of valuation models for products or portfolios is subject to independent approval to ensure only validated models are used. The impact of known limitations of models and data inputs is also monitored on an ongoing basis. IPV is a process that regularly and independently verifies the accuracy and appropriateness of market prices or model inputs used in the valuation of financial instruments. This process assesses fair values using a variety of different approaches to verify and validate the valuations. PAA is a daily process used by management to identify and explain changes in fair value positions across all operating lines of business. This process works in concert with other processes to ensure that the fair values being reported are reasonable. Securities For traded securities, quoted market value is considered to be fair value. Quoted market value is based on bid prices. Securities for which no active market exists are valued using all reasonably available market information. Our fair value methodologies are described below. Government Securities The fair value of government issued or guaranteed debt securities in active markets is determined by reference to recent transaction prices, broker quotes or third-party vendor prices. The fair values of securities that are not traded in an active market are modelled using implied yields derived from the prices of similar actively traded government securities and observable spreads. Market inputs to the model include coupon, maturity and duration. Mortgage-Backed Securities and Collateralized Mortgage Obligations The fair value of mortgage-backed securities and collateralized mortgage obligations is determined by independent prices obtained from third-party vendors, broker quotes and relevant market indices, as applicable. If such prices are not available, fair value is determined using cash flow models that make maximum use of observable market inputs or benchmark prices for similar instruments. Mortgage-backed security and collateralized mortgage obligation valuation assumptions include discount rates, expected prepayments, credit spreads and recoveries. Corporate Debt Securities The fair value of corporate debt securities is determined using prices observed in the most recently executed transactions. When observable price quotations are not available, fair value is determined based on discounted cash flow models using discounting curves and spreads observed from independent dealers, brokers and multi-contributor pricing sources. Corporate Equity Securities The fair value of equity securities is based on quoted prices in active markets, where available. Where quoted prices in active markets are not readily available, fair value is determined based on quoted market prices for similar securities or through valuation techniques, including discounted cash flow analysis and multiples of earnings. Privately Issued Securities Privately issued debt and equity securities are valued using recent prices observed in market transactions, where available. Otherwise, fair value is derived from valuation models using a market or income approach. These models consider various factors, including projected cash flows, earnings, revenue and other third-party evidence, as available. The fair value of limited partnership investments is based upon net asset values published by third-party fund managers. Prices from brokers and multi-contributor pricing sources are corroborated as part of our independent review process, which may include using valuation techniques or obtaining consensus or composite prices from other pricing services. We validate the estimates of fair value by independently obtaining multiple quotes for external market prices and input values. We review the approach taken by third-party vendors to ensure that the vendor employs a valuation model which maximizes the use of observable inputs such as benchmark yields, bidask spreads, underlying collateral, weighted-average terms to maturity and prepayment rate assumptions. Fair value estimates from internal valuation techniques are verified, where possible, by reference to prices obtained from third-party vendors. Loans In determining the fair value of our fixed rate and floating rate performing loans, we discount the remaining contractual cash flows, adjusted for estimated prepayment, at market interest rates currently offered for loans with similar terms. The value of our loan balances determined using this approach is further adjusted by a credit mark that represents an estimate of the expected credit losses in our loan portfolio. Derivative Instruments A number of valuation techniques are employed to estimate fair value, including discounted cash flow analysis, the Black-Scholes model, Monte Carlo simulation and other accepted market models. These vetted models incorporate current market measures for interest rates, currency exchange rates, equity and commodity prices and indices, credit spreads, recovery rates, corresponding market volatility levels, spot prices, correlation levels and other market-based pricing factors. Option implied volatilities, an input into many valuation models, are either obtained directly from market sources or calculated from market prices. Multi-contributor pricing sources are used wherever possible. In determining the fair value of complex and customized derivatives, we consider all reasonably available information, including dealer and broker quotations, multi-contributor pricing sources and any relevant observable market inputs. Our model calculates fair value based on inputs specific to the type of contract, which may include stock prices, correlation for multiple assets, interest rates, foreign exchange rates, yield curves and volatilities. We calculate a credit valuation adjustment ( CVA ) to recognize the risk that any given derivative counterparty may not ultimately be able to fulfill its obligations. The CVA is derived from market-observed credit spreads or proxy credit spreads and our assessment of the net counterparty credit risk exposure, taking into account credit mitigants such as collateral, master netting agreements and settlements through clearing houses. We also calculate a funding valuation adjustment ( FVA ) to recognize the implicit funding costs associated with over the counter derivative positions. The FVA is determined based on reference to market funding spreads. BMO Financial Group 197th Annual Report

3 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Deposits In determining the fair value of our deposits, we incorporate the following assumptions: For fixed rate, fixed maturity deposits, we discount the remaining contractual cash flows for these deposits, adjusted for expected redemptions, at market interest rates currently offered for deposits with similar terms and risks. For fixed rate deposits with no defined maturities, we consider fair value to equal carrying value, based on carrying value being equivalent to the amount payable on the reporting date. For floating rate deposits, changes in interest rates have minimal impact on fair value since deposits re-price to market frequently. On that basis, fair value is assumed to equal carrying value. A portion of our structured note liabilities that have coupons or repayment terms linked to the performance of interest rates, foreign currencies, commodities or equity securities have been designated at fair value through profit or loss. The fair value of these structured notes is estimated using internally vetted valuation models and incorporates observable market prices for identical or comparable securities, and other inputs such as interest rate yield curves, option volatilities and foreign exchange rates, where appropriate. Where observable prices or inputs are not available, management judgment is required to determine the fair value by assessing other relevant sources of information, such as historical data and proxy information from similar transactions. Securities Sold But Not Yet Purchased The fair value of these obligations is based on the fair value of the underlying securities, which can include equity or debt securities. As these obligations are fully collateralized, the method used to determine fair value would be the same as that used for the relevant underlying equity or debt securities. Securities Purchased Under Resale Agreements and Securities Sold Under Repurchase Agreements The fair value of these agreements is determined using a standard discounted cash flow model. Inputs to the model include contractual cash flows and collateral funding spreads. Securitization Liabilities The determination of the fair value of securitization liabilities, recorded in other liabilities, is based on quoted market prices or quoted market prices for similar financial instruments, where available. Where quoted prices are not available, fair value is determined using valuation techniques that maximize the use of observable inputs, as well as assumptions such as discounted cash flows. Subordinated Debt and Capital Trust Securities The fair value of our subordinated debt and capital trust securities is determined by referring to current market prices for similar instruments. Financial Instruments with a Carrying Value Approximating Fair Value Short-term Financial Instruments Carrying value is a reasonable estimate of fair value for certain financial assets and liabilities due to their predominantly short-term nature, such as interest bearing deposits with banks, securities borrowed, customers liability under acceptances, other assets, acceptances, securities lent and certain other liabilities. Other Financial Instruments Carrying value is assumed to be a reasonable estimate of fair value for our cash and cash equivalents and certain other securities. Certain assets, including premises and equipment, goodwill and intangible assets as well as shareholders equity, are not considered financial instruments and therefore no fair value has been determined for these items. For longer-term financial instruments within other liabilities, fair value is determined as the present value of contractual cash flows using discount rates at which liabilities with similar remaining maturities could be issued as at the balance sheet date. Fair Value of Financial Instruments Not Carried at Fair Value on the Balance Sheet Set out in the following tables are the amounts that would be reported if all financial assets and liabilities not currently carried at fair value were reported at their fair values. For the year ended October 31, 2014 (Canadian $ in millions) 2014 Carrying value Fair value quoted market prices models (with observable inputs) models (without observable inputs) Securities Held to maturity 10,344 10, ,652 Other (1) 510 1,829 1,829 10,854 12, ,652 1,829 Securities purchased under resale agreements (2) 33,141 33,095 33,095 Loans Residential mortgages 101, , ,273 Consumer instalment and other personal 64,143 63,280 63,280 Credit cards 7,972 7,706 7,706 Businesses and governments 120, , , , , ,658 Deposits 393, , ,242 Securities sold under repurchase agreements (3) 25,485 25,505 25,505 Other liabilities (4) 23,546 23,927 23,927 Subordinated debt 4,913 5,192 5,192 This table excludes financial instruments with a carrying value approximating fair value such as cash and cash equivalents, interest bearing deposits with banks, securities borrowed, customers liabilities under acceptances, other assets, acceptances, securities lent and certain other liabilities. (1) Excluded from other securities is $477 million of securities related to our merchant banking business that are carried at fair value on the balance sheet. (2) Excludes $20,414 million of securities borrowed for which carrying value approximates fair value. (3) Excludes $14,210 million of securities lent for which carrying value approximates fair value. (4) Other liabilities include securitization and SE liabilities and certain other liabilities of subsidiaries, other than deposits. 180 BMO Financial Group 197th Annual Report 2014

4 For the year ended October 31, 2013 (Canadian $ in millions) 2013 Carrying value Fair value quoted market prices models (with observable inputs) models (without observable inputs) Securities Held to maturity 6,032 6, ,401 Other (1) 411 1,921 1,921 6,443 7, ,401 1,921 Securities purchased under resale agreements (2) 23,174 22,998 22,998 Loans Residential mortgages 96,392 95,944 95,944 Consumer instalment and other personal 63,640 62,770 62,770 Credit cards 7,870 7,619 7,619 Businesses and governments 104, , , , , ,601 Deposits 368, , ,521 Securities sold under repurchase agreements (3) 17,215 17,324 17,324 Other liabilities (4) 22,896 23,182 23,182 Subordinated debt 3,996 4,217 4,217 This table excludes financial instruments with a carrying value approximating fair value such as cash and cash equivalents, interest bearing deposits with banks, securities borrowed, customers liabilities under acceptances, other assets, acceptances, securities lent and certain other liabilities. (1) Excluded from other securities is $488 million of securities related to our merchant banking business that are carried at fair value on the balance sheet. (2) Excludes $16,625 million of securities borrowed for which carrying value approximates fair value. (3) Excludes $11,669 million of securities lent for which carrying value approximates fair value. (4) Other liabilities include securitization and SE liabilities and certain other liabilities of subsidiaries, other than deposits. BMO Financial Group 197th Annual Report

5 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Fair Value Hierarchy We use a fair value hierarchy to categorize financial instruments according to the inputs we use in valuation techniques to measure fair value. The extent of our use of actively quoted market prices (Level 1), internal models using observable market information as inputs (Level 2) and internal models without observable market information as inputs (Level 3) in the valuation of securities, fair value liabilities, derivative assets and derivative liabilities was as follows: (Canadian $ in millions) quoted market prices models (with observable inputs) models (without observable inputs) quoted market prices models (with observable inputs) models (without observable inputs) Trading Securities Canadian federal government 8,737 1,725 8,569 2,255 Canadian provincial and municipal governments 3,134 4,062 1,578 4,133 U.S. federal government 5, ,903 U.S. states, municipalities and agencies Other governments Mortgage-backed securities and collateralized mortgage obligations Corporate debt 1,974 9, ,032 8, Corporate equity 37,221 10,511 28,073 12,014 56,915 27, ,287 27, Available-for-Sale Securities Canadian federal government 4,946 5,555 8,260 4,855 Canadian provincial and municipal governments 1,679 2,425 1,881 1,817 U.S. federal government 1,093 4,660 U.S. states, municipalities and agencies 5, ,388 1 Other governments 2,136 3,996 1,697 4,466 Mortgage-backed securities and collateralized mortgage obligations 9,949 8,805 Corporate debt 5,687 1, ,283 6, Corporate equity , ,963 29,856 1,147 21,244 31, Other Securities Fair Value Liabilities Securities sold but not yet purchased 23,615 3,733 20,024 2,422 Structured note liabilities and other note liabilities 7,785 6,439 Annuity liabilities ,615 11,925 20,024 9,190 Derivative Assets Interest rate contracts 23 18, ,215 Foreign exchange contracts 32 12, ,663 Commodity contracts Equity contracts Credit default swaps , , Derivative Liabilities Interest rate contracts 33 16, ,516 Foreign exchange contracts 33 12, ,443 Commodity contracts 1, Equity contracts 38 3, ,997 Credit default swaps ,205 32, , Certain comparative figures have been reclassified to conform with the current year s presentation. Valuation Techniques and Significant Inputs We determine the fair value of publicly traded fixed maturity and equity securities using quoted prices in active markets (Level 1) when these are available. When quoted prices in active markets are not available, we determine the fair value of financial instruments using models such as discounted cash flows with observable market data for inputs such as yield and prepayment rates or broker quotes and other third-party vendor quotes (Level 2). Fair value may also be determined using models where significant market inputs are not observable due to inactive markets or minimal market activity (Level 3). We maximize the use of market inputs to the extent possible. Our Level 2 trading securities are primarily valued using discounted cash flow models with observable spreads or broker quotes. The fair value of Level 2 available-for-sale securities is determined using discounted cash flow models with observable spreads or third-party vendor quotes. Level 2 structured note liabilities are valued using models with observable market information. Level 2 derivative assets and liabilities are valued using industry-standard models and observable market information. 182 BMO Financial Group 197th Annual Report 2014

6 Quantitative Information about Level 3 Fair Value Measurements The table below presents the fair values of our significant Level 3 financial instruments, the valuation techniques used to determine their fair values and the value ranges of significant unobservable inputs used in the valuations. As at October 31, 2014 (Canadian $ in millions, except as noted) Fair value Range of input values (1) Reporting line in fair value hierarchy table Assets Liabilities Valuation techniques Significant unobservable inputs Low High Securities Private equity (2) Corporate equity 1,138 Net Asset Value EV/EBITDA Net Asset Value Multiple na 5.5x na 8.9x Collateralized loan obligations securities (3) Corporate debt 546 Discounted Cash Flow Model Yield/Discount Margin 1.15% 1.15% Merchant banking securities Other 467 Net Asset Value EV/EBITDA Net Asset Value Multiple na 4.4x na 9.2x (1) The low and high input values represent the actual highest and lowest level of inputs used to value a group of financial instruments in a particular product category. These input ranges do not reflect the level of input uncertainty, but are affected by the specific underlying instruments within the product category. The input ranges will therefore vary from period to period based on the characteristics of the underlying instruments held at each balance sheet date. (2) Included in private equity is $600 million of Federal Reserve Bank and U.S. Federal Home Loan Bank shares that we hold to meet regulatory requirements. These shares are carried at cost, which is deemed to approximate fair value as a result of these shares not being traded in the market. (3) Includes both trading and available-for-sale instruments. na not applicable Significant Unobservable Inputs in Level 3 Instrument Valuations Net Asset Value Net asset value represents the estimated value of a security based on valuations received from the investment or fund manager. The valuation of certain private equity securities is based on the economic benefit derived from our investment. EV/EBITDA Multiple The fair value of private equity and merchant banking investments is derived by calculating an enterprise value ( EV ) using the EV/EBITDA multiple and then proceeding through a waterfall of the company s capital structure to determine the value of the assets or securities we hold. The EV/EBITDA multiple is determined using judgment in considering factors such as multiples for comparable listed companies, recent transactions and company-specific factors, as well as liquidity discounts that account for the lack of active trading in these assets and securities. Yield/Discount Margin A financial instrument s yield is the interest rate used to discount future cash flows in a valuation model. An increase in the yield, in isolation, would result in a decrease in the related fair value measurement. The discount margin is the difference between a debt instrument s yield and a benchmark instrument s yield. Benchmark instruments have high credit quality ratings and similar maturities and are often government bonds. The discount margin for an instrument forms part of the yield used in a discounted cash flow calculation. Generally, an increase in the discount margin will result in a decrease in fair value. Sensitivity Analysis of Level 3 Instruments Sensitivity analysis at October 31, 2014 for significant Level 3 instruments, that is securities which represent greater than 10% of Level 3 instruments, is provided below. Within Level 3 trading securities is corporate debt of $538 million related to securities that are hedged with credit default swaps that are also considered to be Level 3 instruments. As at October 31, 2014, the derivative assets and derivative liabilities were valued at $12 million and $8 million, respectively. We have determined the valuation of these derivatives and the related securities based on market-standard models we use to model the specific collateral composition and cash flow structure of the related deal. As at October 31, 2014, the impact of assuming a 10 basis point increase or decrease in the discount margin would be a $1 million decrease or increase in fair value, respectively. We have not applied another reasonably possible alternative assumption to the significant Level 3 categories of private equity investments and merchant banking securities, as the net asset values are provided by the investment or fund managers. Significant Transfers Our policy is to record transfers of assets and liabilities between fair value hierarchy levels at their fair values as at the end of each reporting period, consistent with the date of the determination of fair value. Transfers are made between the various fair value hierarchy levels that result from changes in the availability of quoted market prices or observable market inputs that result from changing market conditions. The following is a discussion of the significant transfers between Level 1, Level 2 and Level 3 balances for the year ended October 31, During the year ended October 31, 2014, $584 million of trading securities and $8 million of available-for-sale securities were transferred from Level 1 to Level 2 due to reduced observability of the inputs used to value these securities. During the year ended October 31, 2014, $1,140 million of trading securities and $1,481 million of available-forsale securities were transferred from Level 2 to Level 1 due to increased availability of quoted prices in active markets. During the year ended October 31, 2014, $4 million of available-forsale securities were transferred from Level 2 to Level 3 as a result of fewer available prices for these securities during the year. During the year ended October 31, 2014, $15 million of trading securities and $12 million of available-for-sale securities were transferred from Level 3 to Level 2 as market information became available for certain corporate debt securities. BMO Financial Group 197th Annual Report

7 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Changes in Level 3 Fair Value Measurements The table below presents a reconciliation of all changes in Level 3 financial instruments during the year ended October 31, 2014, including realized and unrealized gains (losses) included in earnings and other comprehensive income. For the year ended October 31, 2014 (Canadian $ in millions) Balance October 31, 2013 Change in fair value Included in earnings Included in other comprehensive income Purchases Sales Maturities/ Settlement (1) Transfers into Level 3 Transfers out of Level 3 Fair value as at October 31, 2014 Unrealized gains (losses) (2) Trading Securities U.S. states, municipalities and agencies Corporate debt (66) (268) (15) Total trading securities (66) (268) (15) Available-for-Sale Securities U.S. states, municipalities and agencies 1 1 Corporate debt 30 (1) (21) 8 Corporate equity 949 (37) (53) 4 (12) 1, Total available-for-sale securities 980 (38) (74) 4 (12) 1, Other Securities (156) Derivative Assets Credit default swaps 28 (16) 12 (16) Derivative Liabilities Credit default swaps 19 (11) 8 (11) (1) Includes cash settlement of derivative assets and derivative liabilities. (2) Unrealized gains or losses on trading securities, derivative assets and derivative liabilities held on October 31, 2014 are included in earnings in the year. For available-for-sale securities, the unrealized gains or losses on securities held on October 31, 2014 are included in Accumulated Other Comprehensive Income. 184 BMO Financial Group 197th Annual Report 2014

8 The table below presents a reconciliation of all changes in Level 3 financial instruments during the year ended October 31, 2013, including realized and unrealized gains (losses) included in earnings and other comprehensive income. For the year ended October 31, 2013 (Canadian $ in millions) Balance October 31, 2012 Change in fair value Included in earnings Included in other comprehensive income Purchases Sales Maturities / Settlement (1) Transfers into Level 3 Transfers out of Level 3 Fair value as at October 31, 2013 Unrealized gains (losses) (2) Trading Securities Canadian provincial and municipal governments 73 1 (46) (28) U.S. states, municipalities and agencies Mortgage-backed securities and collateralized mortgage obligations (378) (39) 17 Corporate debt 1, (227) (327) Total trading securities 1, (651) (366) 17 (28) Available-for-Sale Securities U.S. states, municipalities and agencies 9 (8) 1 Corporate debt (10) (2) (29) 30 1 Corporate equity 942 (19) (135) (4) Total available-for-sale securities 993 (19) (153) (2) (33) Other Securities (138) Derivative Assets Interest rate contracts 3 (3) (3) Equity contracts 5 (1) (4) Credit default swaps 37 (9) 28 (9) Total derivative assets 45 (12) (1) (4) 28 (12) Derivative Liabilities Interest rate contracts 20 (20) (20) Equity contracts (3) 6 (62) Foreign exchange contracts 2 (2) Credit default swaps (17) Total derivative liabilities (3) 6 (64) 19 (37) (1) Includes cash settlement of derivative assets and derivative liabilities. (2) Unrealized gains or losses on trading securities, derivative assets and derivative liabilities held on October 31, 2013 are included in earnings in the year. For available-for-sale securities, the unrealized gains or losses on securities held on October 31, 2013 are included in Accumulated Other Comprehensive Income. BMO Financial Group 197th Annual Report